ETF Speed Dating: Chemistry to Compatibility to Commitment

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Ticker Tape Editors

March 10, 2016

Do exchange-traded funds make a good match for your portfolio? Start with a basic compatibility test.

Long before you ever take them home to meet mother, spend a little time getting to know exchange-traded funds (ETFs). Sure, they’ve attracted mainstream investor attention for nearly two decades now, so you may already know a thing or two (or think you do). News, promotions, and analyst coverage of these actively tradable, index-like products probably flood your inboxes as new ETFs roll out all the time.

Whether you’re just starting out, or in need of a little refresher, let us give you a quick introduction, or reintroduce you, to ETFs:

ETFs are baskets of securities that typically track a sector-specific, country-specific, or a narrow- or broad-market index and are thus considered to be passively managed (someone isn’t actively choosing which stocks to buy and sell). They list on an exchange like a stock so you can conveniently trade them through your brokerage account. They can appeal to active traders and hands-off investors alike. ETFs’ role (offering diversification, hedging, potential income, and a potential tax benefit with fewer capital gains) can evolve with your investment goals and risk profile. That relationship can even change with the ups and downs of the market.

Vital Statistics

How ETFs Differ From Mutual Funds

DIVERSE ETFs (all mutual funds actually) typically hold dozens, and hundreds in some cases, of stocks linked by theme. For instance: companies in the S&P 500 index; a specific sector like financial or biotech; bonds; commodities; or real estate. Plus, ETFs can be a relatively convenient way to gain exposure to foreign indexes or individual shares.

ACCESSIBLE ETFs change hands throughout the day and in most after-hours sessions on the major stock exchanges. Like any investment, some feature greater volume (and thus, potentially deeper liquidity) than others. By contrast, traditional index funds can only be redeemed at the closing price of each trading day. And some mutual funds are confined by “lockout” periods that restrict closing and reopening a position for up to as much as 60 days; not so for ETFs.

APPROACHABLE Proponents like ETFs because they offer index-like investing at a relatively low admission price and with potentially tamer upkeep costs compared to individual stock ownership. Like stocks, some ETFs pay dividends. For investors with limited funds (say, less than $1,000) ETFs can offer a way in to the stock market. Keep in mind, fees, commissions, and other potential costs, including capital gains taxes can apply to ETFs.

Good Chemistry?

• COMFORT LEVEL The risks of index ETFs are typically limited to the same percentage risks as the indexes they track. The risks of sector-based ETFs depend on the basket of stocks they track, including the weighting of each stock. Because you can choose broad-based indexes or narrower industry choices, index and sector ETFs can be a starting point.

• TRADERS TOO Contrary to some thinking, ETFs can be a good fit for active market participants too; they can be shorted, hedged (with an offsetting position), bundled (buying several at one time as a potential cost-saver) and many have options traded on them. They sometimes bring less volatility than individual stocks, yet potentially more flexibility than mutual funds. Active traders might consider ETFs as a diversifier to deal with potential “surprises” that can accompany trading individual issues of stock.

• IT’S COMPLICATED (SOMETIMES) ETFs have gotten more specialized over the years. Experienced investors might consider “hybrid” ETFs that are leveraged, inverse, sometimes both. Special risks are associated with these funds. Before trading these very distinctive products, be sure to learn the risks, and keep in mind that most of these are intended for very short holding times, often as short as one day.

• TAKING IT SLOW ETFs aren’t for everyone and certainly, not every situation. For instance, no-load mutual index funds might be a better fit than ETFs if you prefer dollar-cost averaging. That’s where you build up a portfolio slowly and in pre-set increments. ETF trading costs could pile up, eating up your potential profit, if using such a strategy. For instance, the transaction costs associated with buying one share at a time can be prohibitively high.

Background Check

• SKIN DEEP ETFPopularity has forced the marketing folks to get creative with naming this product and catchy acronyms and action words keep ETF proper names easy on the tongue. But be sure to look at what’s behind a name by scrutinizing an ETF’s holdings and objectives as you would those of any mutual fund. Make sure the ETF label matches the underlying securities.

• CHEAP DATE? By construction, ETF investors have less exposure to capital gains taxes than actively managed mutual fund shareholders. That’s because mutual fund managers frequently buy and sell the fund’s holdings, ideally at a profit, and pass along those tax obligations to shareholders. ETFs occasionally move shares around, too, although much less than most managed mutual funds. Annual expenses for ETFs range between 0.1% and 0.65%, according to fund-tracker Morningstar, Inc. Index mutual funds tend to charge anywhere from 0.1% to an average 1.5% (the high end reflects actively managed), according to the Investment Company Institute.

Play The Field

• SHORT PLAY Select ETFs can help investors hedge a portfolio of stocks against potential volatility in the market. For instance, you might consider selling a comparable index ETF against your portfolio so that if the market does drop, the loss on your portfolio may be reduced with gains in the short ETF. Keep in mind, though, that the risk of loss on a short sale is potentially unlimited since there is no limit to the price increase of a security.

• BEWARE…BETA They may track the same stocks and offer easy diversification, but subtle differences between index mutual funds and ETFs can affect long-term returns. ETFs (stocks, too) have beta, a measure of the volatility of a security or portfolio compared to a market or index. This means that ETFs can move up and down with the broader market. For instance, if your portfolio is centered largely on small- and mid-cap stocks, investing in the broad-based ETF QQQ, which tracks the Nasdaq- 100 Index, would add more of the same type of risk to your portfolio. That’s adding beta. A beta-beater, then, might include adding the Nasdaq 100-tracking QQQ when the bulk of the rest of your portfolio is closely aligned to the broader S&P 500.

• YOU HAVE OPTIONS Options on index ETFs are often used by traders as a first entry in to the world of options. That’s because many ETFs have single points between strikes. Single-point strikes help new investors define the maximum risk even before executing the trade. ETFs can keep investors focused on defining maximum risk, plus they can be relatively less volatile than individual stocks. For example, if the value of the difference of adjacent strikes is $100, you might create option spreads with a maximum potential loss of $100 or less. Options are not available on all ETFs.

Committed Relationship

For some investors, ETFs may be best used as a long-term investment tool that’s not so actively traded. This can work too. The same reasons that you fell for them in the first place apply; they can be diverse, accessible, and approachable. (Their potential flaws don’t go away either; watch beta, volatility). All told, the longer-term role of ETFs in your portfolio is rather straight-forward: filling out asset allocation gaps and replacing potentially higher-fee mutual funds.

So, what do you think? Another date?

Screen Test

Use a screener to narrow the field of ETFs that might best fit your goals at TD Ameritrade's ETF Market Center. Pre-defined and custom screens can help you filter through sector funds, target-date funds, bear-market funds, and more.

Carefully consider the investment objectives, risks, charges, and expenses of an exchange traded fund before investing. A prospectus, obtained by calling 800-669-3900, contains this and other important information about an investment company. Read carefully before investing.

ETFs can entail risks similar to direct stock ownership, including market, sector, or industry risks. Some ETFs may involve international risk, currency risk, commodity risk, and interest rate risk. Trading prices may not reflect the net asset value of the underlying securities. Not all ETFs offer option availability. Options involve risks and are not suitable for all investors. Commission fees typically apply.

Spreads and other multi-leg option transactions will incur contract fees on each leg of the order, which may impact any potential return.

The risk of loss on a short sale is potentially unlimited since there is no limit to the price increase of a security.

There is no guarantee the brokerage firm can continue to maintain a short position for an unlimited time period. Your position may be closed out by the firm without regard to your profit or loss.

TD Ameritrade does not provide tax advice. We suggest you consult with a tax-planning professional with regard to your personal circumstances.

Diversification does not eliminate the risk of experiencing investment losses.

Morningstar Investment Management, LLC and the Investment Company Institute are separate and not affiliated with TD Ameritrade, which is not responsible for their content, services, opinions, or policies.

Market volatility, volume, and system availability may delay account access and trade executions.

Past performance of a security or strategy does not guarantee future results or success.

Options are not suitable for all investors as the special risks inherent to options trading may expose investors to potentially rapid and substantial losses. Options trading subject to TD Ameritrade review and approval. Please read Characteristics and Risks of Standardized Options before investing in options.

Supporting documentation for any claims, comparisons, statistics, or other technical data will be supplied upon request.

The information is not intended to be investment advice or construed as a recommendation or endorsement of any particular investment or investment strategy, and is for illustrative purposes only. Be sure to understand all risks involved with each strategy, including commission costs, before attempting to place any trade. Clients must consider all relevant risk factors, including their own personal financial situations, before trading.

This is not an offer or solicitation in any jurisdiction where we are not authorized to do business or where such offer or solicitation would be contrary to the local laws and regulations of that jurisdiction, including, but not limited to persons residing in Australia, Canada, Hong Kong, Japan, Saudi Arabia, Singapore, UK, and the countries of the European Union.